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LEVEL 3 COMMUNICATIONS INC - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(Edgar Glimpses Via Acquire Media NewsEdge) The following discussion should be read in conjunction with the Level 3 Communications, Inc. and its subsidiaries ("Level 3" or the "Company") Consolidated Financial Statements (including the notes thereto), included elsewhere herein and the Company's Form 10-K for the year ended December 31, 2013, filed with the Securities and Exchange Commission. This document contains forward looking statements and information that are based on the beliefs of management as well as assumptions made by and information currently available to the Company. When used in this document, the words "anticipate", "believe", "plan", "estimate" and "expect" and similar 36-------------------------------------------------------------------------------- Table of Contents expressions, as they relate to the Company or its management, are intended to identify forward-looking statements. Such statements reflect the current views of the Company with respect to future events and are subject to certain risks, uncertainties and assumptions. Should one or more of these risks or uncertainties materialize, or should underlying assumptions prove incorrect, actual results may vary materially from those described in this document. For a more detailed description of these risks and factors, please see the Company's Form 10-K for the year ended December 31, 2013, filed with the Securities and Exchange Commission and Item 1A in Part II of this Form 10-Q. Executive Summary Disaggregation of Network Related Expenses; Change in Description of Cost of Revenue to Network Access Costs Historically, the Company has included "network related expenses" including facility rent, utilities, maintenance and other costs, each related to the operation of Level 3's communications network, as well as salaries, wages and related benefits (including non-cash stock-based compensation expenses) associated with personnel who are responsible for the delivery of services as well as operation and maintenance of its communications network, and accretion expense on asset retirement obligations, but excluding depreciation and amortization, within the line item "Selling, General and Administrative Expenses" in its Consolidated Statement of Operations. Beginning with the third quarter 2014, these network related expenses will be reported under a separate line item, "Network Related Expenses," in the Company's Consolidated Statement of Operations. Beginning with the third quarter 2014, "Selling General and Administrative Expenses" include the salaries, wages and related benefits (including non-cash, stock-based compensation expenses) and the related costs of corporate and sales personnel, travel, insurance, non-network related rent, advertising and other administrative expenses. In addition, the Company has changed the description of "Cost of Revenue" in its Consolidated Statement of Operations to "Network Access Costs." Network Access Costs include leased capacity costs, right-of-way costs, access charges, satellite transponder lease costs and other third party costs directly attributable to providing access to customer locations from the Level 3 network. Network Access Costs exclude Network Related Expenses, and depreciation and amortization. Network Access Costs do not include any employee expenses or impairment expenses; these expenses are allocated to Network Related Expenses or Selling, General and Administrative Expenses. The changes outlined above do not affect the Company's previously reported Consolidated Total Costs and Expenses, Operating Income, Net Loss or Loss per Share in the Consolidated Statement of Operations, or any items reported in the Consolidated Balance Sheets, Consolidated Statements of Comprehensive Loss, Cash Flows or Changes in Stockholders' Equity (Deficit). The following table reflects on an unaudited basis the change of the description of "Cost of Revenue" to "Network Access Costs" and the disaggregation of "Network Related Expenses" from "Selling, General and Administrative Expenses" for the three and nine months ended September 30, 2013 in the Consolidated Statements of Operations, assuming the changes discussed above were in effect for the entire period reported below. 37-------------------------------------------------------------------------------- Table of Contents As Previously Adjustment Revised Reporting (dollars in millions) Reported (1) Three Months Ended September 30, 2013 Cost of Revenue $ 608 $ (608 ) $ - Network Access Costs - 608 608 Network Related Expenses - 314 314 Selling, General and Administrative Expenses 606 (314 ) 292 Total Costs and Expenses 1,417 - 1,417 Nine Months Ended September 30, 2013 Cost of Revenue $ 1,853 $ (1,853 ) $ - Network Access Costs - 1,853 1,853 Network Related Expenses - 916 916 Selling, General and Administrative Expenses 1,815 (916 ) 899 Total Costs and Expenses 4,264 - 4,264 (1) The description of "Cost of Revenue" has been changed to "Network Access Costs" and the presentation of "Network Related Expenses" has been disaggregated from "Selling, General and Administrative Expenses" in the Consolidated Statements of Operations for the three and nine months ended September 30, 2013. As a result of the above, the Company also revised the Condensed Consolidating Statements of Operations for the three and nine months ended September 30, 2013 in Note 11 - Condensed Consolidating Financial Information. Overview The Company is a facilities-based provider of a broad range of communications services. Revenue for communications services is generally recognized on a monthly basis as these services are provided. For contracts involving private line, wavelength and dark fiber services, Level 3 may receive upfront payments for services to be delivered for a period of generally up to 25 years. In these situations, Level 3 defers the revenue and amortizes it on a straight-line basis to earnings over the term of the contract. Business Strategy and Objectives The Company pursues the strategies discussed in Item 1. Business, "Business Overview and Strategy" as discussed in its Form 10-K for the year ended December 31, 2013. In particular, with respect to strategic financial objectives, the Company focuses its attention on the following: • growing revenue by increasing sales generated by our Core Network Services; • focusing on our enterprise customers, as this customer group has the largest potential for significant growth; • continually improving the customer experience to increase customer retention and reduce customer churn; 38-------------------------------------------------------------------------------- Table of Contents • launching new products and services to meet customer needs, in particular for enterprise customers; • reducing network costs and operating expenses; • achieving sustainable generation of positive cash flows from operations; • continuing to show improvement in Adjusted EBITDA (as defined in this Item below) as a percentage of revenue; • localizing certain decision making and interactions with our mid-market enterprise customers, including leveraging our existing network assets; • concentrating its capital expenditures on those technologies and assets that enable the Company to develop its Core Network Services; • managing Wholesale Voice Services for profit contribution; and • successfully integrating the operations of acquisitions, including tw telecom. The Company's management continues to review all existing lines of business and service offerings to determine how those lines of business and service offerings enhance the Company's focus on the delivery of communications services and meeting its financial objectives. To the extent that certain lines of business or service offerings are not considered to be compatible with the delivery of the Company's services or with meeting its financial objectives, Level 3 may exit those lines of business or stop offering those services in part or in whole. The Company has also been focused on improving its liquidity and financial condition, and extending the maturity dates of certain debt. The Company will continue to look for opportunities to improve its financial position and focus its resources on growing profitable revenue and managing costs for the business. Revenue by Channel: Three Months Ended September 30, Nine Months Ended September 30, (dollars in millions) 2014 2013 2014 2013 Core Network Services: North America - Wholesale Channel $ 368 $ 365 $ 1,103 $ 1,104 North America - Enterprise Channel 695 622 2,054 1,820 EMEA - Wholesale Channel 80 88 253 265 EMEA - Enterprise Channel 139 134 420 400 Latin America - Wholesale Channel 42 39 124 119 Latin America - Enterprise Channel 158 149 464 440 Total Core Network Services 1,482 1,397 4,418 4,148 Wholesale Voice Services and Other 147 172 445 563 Total Revenue $ 1,629 $ 1,569 $ 4,863 $ 4,711 Total revenue consists of: 39-------------------------------------------------------------------------------- Table of Contents • Core Network Services revenue from colocation and data center services; transport and fiber; IP and data services; and local and enterprise voice services. • Wholesale Voice Services and Other revenue from sales of long distance voice services. Core Network Services revenue represents higher profit services and Wholesale Voice Services and Other revenue represents lower profit services. Core Network Services revenue requires different levels of investment and focus and provides different contributions to the Company's operating results than Wholesale Voice Services and Other revenue. Management believes that growth in revenue from its Core Network Services is critical to the long-term success of its business. The Company also believes it must continue to effectively manage the profitability of the Wholesale Voice Services component. The Company believes that trends in its communications business are best gauged by analyzing revenue changes in Core Network Services. Core Network Services Colocation and data center services allow customers to place their network equipment and servers in suitable environments maintained by the Company with high-speed links providing on-net access to more than 60 countries. These services are secure, redundant and flexible to fit the varying needs of the Company's customers. Services, which vary by location, include hosting network equipment used to transport high speed data and voice over Level 3's global network; connectivity associated with Cloud services; providing managed IT services, installation, maintenance, storage and monitoring of enterprise services; and providing comprehensive IT outsource solutions. Growth in transport (such as private line and wavelengths) and fiber revenue is largely dependent on increased demand for bandwidth services and available capital of companies requiring communications capacity for their own use or in providing capacity as a service provider to their customers. These expenditures may be in the form of monthly payments or, in the case of private line, wavelength or dark fiber services, either monthly payments or upfront payments. The Company is focused on providing end-to-end transport and fiber services to its customers to directly connect customer locations with a private network. Pricing for end-to-end metropolitan transport services have been relatively stable. For intercity transport and fiber services, the Company continues to experience pricing pressure in locations where a large number of carriers co-locate their facilities. An increase in demand may be offset by declines in unit pricing. Internet Protocol ("IP") and data services primarily include the Company's Internet services, Virtual Private Network ("VPN"), Content Delivery Network ("CDN"), media delivery, Vyvx broadcast, Converged Business Network ("CBN"), and Managed Services. Level 3's IP and high speed IP service is high quality and is offered in a variety of capacities. The Company's VPN service permits businesses of any size to replace multiple networks with a single, cost-effective solution that greatly simplifies the converged transmission of voice, video and data. This convergence to a single platform can be obtained without sacrificing the quality of service or security levels of traditional ATM and frame relay offerings. VPN service also permits customers to prioritize network application traffic so that high priority applications, such as voice and video, are not compromised in performance by the flow of low priority applications such as email. Voice services comprise a broad range of local and enterprise voice services using Voice over Internet Protocol ("VoIP") and traditional circuit-switch based technologies, including VoIP enhanced local service, SIP Trunking, local inbound service, Primary Rate Interface service, long distance service and toll-free service. SIP Trunking allows customers with an IP PBX to manage calls to and from the public switched telephone network ("PSTN") without having to purchase traditional access lines dedicated to voice. The Company's voice services also include its comprehensive suite of audio, Web and video collaboration services. 40-------------------------------------------------------------------------------- Table of Contents The Company believes that a source of future incremental demand for the Company's Core Network Services will be from customers that are seeking to distribute their feature rich content or video over the Internet. Revenue growth in this area is dependent on the continued increase in demand from customers and the pricing environment. An increase in the reliability and security of information transmitted over the Internet and declines in the cost to transmit data have resulted in increased utilization of e-commerce or Web-based services by businesses. Although the pricing for data services is currently relatively stable, the IP market is generally characterized by price compression and high unit growth rates depending upon the type of service. The following provides a discussion of the Company's Core Network Services revenue in terms of the enterprise and wholesale channels. • The enterprise channel includes large, multi-national enterprises requiring large amounts of bandwidth to support their business operations, such as financial services companies, healthcare companies, content providers, retail companies and portal and search engine companies. It also includes medium sized enterprises, as well as government markets, including the U.S. federal government, the systems integrators supporting the U.S. federal government, U.S. state and local governments, academic consortia and certain academic institutions. • The wholesale channel includes revenue from incumbent and alternative carriers in each of the regions, global carriers, wireless carriers, cable companies, satellite companies, regional service providers and voice service providers. The Company believes that the alignment of Core Network Services around channels should allow it to drive growth while enabling it to better focus on the needs of its customers. Each of these channels is supported by dedicated employees in sales. Each of these channels is also supported by non-dedicated, centralized service delivery and management, product management and development, corporate marketing, global network services, engineering, information technology and corporate functions, including legal, finance, strategy and human resources. Wholesale Voice Services and Other The Company offers wholesale voice services that target large and existing markets. The revenue potential for wholesale voice services is large; however, pricing is expected to continue to decline over time as a result of the new low-cost IP and optical-based technologies. In addition, the overall market for wholesale voice services is declining and is also being targeted by many competitors, several of which are larger and have more financial resources than the Company. The Company also has other revenue derived from mature services that are not critical areas of emphasis for the Company. The Company expects ongoing declines in Wholesale Voice Services and Other similar to what has been experienced over the past several years. The Company receives compensation from other carriers when it terminates traffic originating on those carriers' networks. This intercarrier compensation is based on interconnection agreements with the respective carriers or rates mandated by the Federal Communications Commission ("FCC"). The Company has interconnection agreements in place for the majority of traffic subject to intercarrier compensation. Along with addressing other matters, on November 18, 2011, the FCC established a prospective intercarrier compensation framework for terminating switched access and VoIP traffic, with elements of it becoming effective beginning on December 29, 2011. Under the framework, most terminating switched access charges and all intercarrier compensation charges are capped at current levels, and will be reduced to zero over, as relevant to Level 3, a six year transition period which began July 1, 2012. Several states, industry groups, and other telecommunications carriers filed petitions in federal court for reconsideration of the framework with the FCC, although the outcome of those petitions is unpredictable. A majority of the Company's existing intercarrier compensation revenue is associated 41-------------------------------------------------------------------------------- Table of Contents with agreements that have expired terms, but remain effective in evergreen status. As these and other interconnection agreements expire, the Company will continue to evaluate simply allowing them to continue in evergreen status (so long as the counterparty allows the same) or negotiating new agreements. The Company earned intercarrier compensation revenue from providing managed modem services, which it has discontinued. The Company also receives intercarrier compensation from its voice services. In this case, intercarrier compensation is reported within Core Network Services revenue. For a detailed description of the Company's broad range of communications services, please see Item 1. "Business - Our Service Offerings" of the Company's Form 10-K for the year ended December 31, 2013, filed with the Securities and Exchange Commission. Seasonality and Fluctuations The Company continues to expect business fluctuations to affect sequential quarterly trends in revenue, costs and cash flow. This includes the timing, as well as any seasonality of sales and service installations, usage, rate changes and repricing for contract renewals. Historically, the Company's revenue and expense in the first quarter has been affected by the slowing of our customers' purchasing activities during the holidays and the resetting of payroll taxes in the new year. The Company's historical experience with quarterly fluctuations may not necessarily be indicative of future results. Because revenue subject to billing disputes where collection is uncertain is not recognized until the dispute is resolved, the timing of dispute resolutions and settlements may positively or negatively affect the Company's revenue in a particular quarter. The timing of disconnections may also affect our results in a particular quarter, with disconnections early in the quarter generally having a greater effect. The timing of capital and other expenditures may affect our costs or cash flow. The convergence of any of these or other factors such as fluctuations in usage, increases or decreases in certain taxes and fees or pricing declines upon contract renewals in a particular quarter may result in the Company's revenue growing more or less than previous trends, may affect the Company's profitability and other financial results and may not be indicative of future financial performance. Merger of tw telecom inc. On October 31, 2014, the Company and two of its subsidiaries completed the merger with tw telecom inc. ("tw telecom") and tw telecom became a wholly owned subsidiary of the Company through a tax-free, stock and cash reorganization (the "Merger"). As a result of the Merger, (1) each issued and outstanding share of common stock of tw telecom was exchanged for 0.7 shares of Level 3 common stock and $10 in cash ( together the "merger consideration"); (2) the outstanding stock options were canceled and holders received the merger consideration, net of aggregate per share exercise price; (3) each restricted stock unit award was canceled and holders received the merger consideration; and (4) each restricted stock unit was immediately vested and canceled and the holders received the merger consideration. In connection with the closing of the Merger, Level 3 Financing amended its existing credit agreement to incur an additional $2 billion of borrowings through an additional Tranche (the "Tranche B 2022 Term Loan"). The aggregate net proceeds of Level 3 Financing's Tranche B 2022 Term Loan issued in October 2014 were used to finance the cash portion of the merger consideration payable to tw telecom's stockholders and to refinance certain existing indebtedness of tw telecom, including fees and premiums, in connection with the closing of the Merger (see Note 12 - Subsequent Events for additional information). In addition, the $1.0 billion of proceeds from the 5.375% Senior Notes due 2022 raised in August 2014 (see Note 6 - Long-Term Debt) by an an indirect, wholly owned subsidiary were deposited into an escrow account. On October 31, 2014, following the consummation of the Merger and the satisfaction of certain escrow release conditions, the 5.375% Senior Notes were assumed by Level 3 Financing and the funds were released from the escrow account. The net proceeds from the 5.375% Senior Notes were used to finance the cash portion of the merger consideration payable to tw telecom 42-------------------------------------------------------------------------------- Table of Contents stockholders and to refinance certain existing indebtedness of tw telecom, including fees and premiums, in connection with the closing of the Merger. On October 30, 2014, the Company increased the number of authorized shares of common stock by 100,000,000 shares to 433,333,333. As a result of the Merger, the Company issued approximately 96.9 million shares of Level 3 common stock to former holders of tw telecom common shares, stock options, restricted stock units and restricted stock awards. In addition, Level 3 called for redemption and discharged or repaid approximately $1.793 billion of tw telecom's outstanding consolidated debt. The shares of tw telecom common stock, which previously traded under the symbol "TWTC", ceased trading on the NASDAQ Global Select Market ("NASDAQ") at the close of trading on October 31, 2014 and were delisted from NASDAQ. Based on the number of Level 3 shares issued, the closing stock price of $46.91 on October 31, 2014, the cash paid to the former holders of tw telecom common stock and the $1.793 billion of debt of tw telecom called for redemption and discharged or repaid, the aggregate consideration for acquisition accounting, including assumed debt, approximated $8.1 billion. The premium paid by Level 3 in this transaction is attributable to strategic benefits, as the transaction further solidifies Level 3's position as a premier global communications provider to the enterprise, government and carrier market, combining tw telecom's extensive local operations and assets in North America with Level 3's global assets and capabilities. tw telecom's business model is directly aligned with Level 3's initiatives for growth, which include building managed solutions to meet customer needs through an advanced IP/optical network. Critical Accounting Policies Refer to Item 7 of the Company's Form 10-K for the year ended December 31, 2013, for a description of the Company's critical accounting policies. Property, Plant and Equipment The Company performs internal reviews to evaluate the estimated depreciable lives of its property, plant and equipment annually or more frequently if new facts and circumstances arise that may affect management's original estimates. Due to the rapid changes in technology and the competitive environment, selecting the estimated economic life of telecommunications property, plant and equipment requires a significant amount of judgment. The Company's internal reviews take into account input from the Company's global engineering and network services personnel, actual usage, the physical condition of the Company's property, plant and equipment, industry data and other relevant factors. In connection with its periodic review of the estimated useful lives of property, plant and equipment, the Company completed its evaluation in the first quarter of 2014 and determined that the period it expects to use certain assets is longer than the remaining originally estimated useful lives. The Company revised its estimated useful lives for: IP equipment from its historical estimate of four years to a revised estimate of seven years; racks and cabinets from its historical estimate of seven years to a revised estimate of 15 years; and facility equipment from its historical estimate of 10 years to its revised estimate of 15 years. In determining the change in estimated useful lives, the Company, with input from its engineering team, considered its historical usage patterns and retirements, estimates of technological obsolescence, and expected usage and maintenance. The change in the estimated useful lives of certain of the Company's property, plant and equipment was accounted for as a change in accounting estimate on a prospective basis effective January 1, 2014 under the accounting standard related to changes in accounting estimates. The carrying values of assets subject to these revisions were (in millions): 43-------------------------------------------------------------------------------- Table of Contents January 1, 2014 IP Equipment $ 222 Racks and Cabinets 114 Facility Equipment 151 $ 487 The change in estimated useful lives of certain of the Company's property, plant and equipment resulted in less depreciation expense than would have otherwise been recorded and in the following increase in net income and net income per share for the nine months ended September 30, 2014 (in millions, except per share amounts): Net Income $ 75 Basic Net Income per Share $ 0.32 Diluted Net Income per Share $ 0.31 44-------------------------------------------------------------------------------- Table of Contents Results of Operations for the Three and Nine Months Ended September 30, 2014 vs. 2013 Three Months Ended September 30, Nine Months Ended September 30, (dollars in millions) 2014 2013 Change % 2014 2013 Change % Revenue $ 1,629 $ 1,569 4 % $ 4,863 $ 4,711 3 % Network Access Costs 607 608 NM 1,834 1,853 (1 )% Network Related Expenses 307 314 (2 )% 901 916 (2 )% Depreciation and Amortization 187 203 (8 )% 558 596 (6 )% Selling, General and Administrative Expenses 266 292 (9 )% 788 899 (12 )% Total Costs and Expenses 1,367 1,417 (4 )% 4,081 4,264 (4 )% Operating Income 262 152 72 % 782 447 75 % Other Income (Expense): Interest Income 1 - NM 1 - NM Interest expense (159 ) (165 ) (4 )% (459 ) (501 ) (8 )% Gain (Loss) on modification and extinguishment of debt, net - (17 ) (100 )% - (17 ) (100 )% Other, net (11 ) 23 NM (49 ) (13 ) 277 % Total Other Expense (169 ) (159 ) 6 % (507 ) (531 ) (5 )% Income (Loss) Before Income Taxes 93 (7 ) NM 275 (84 ) NM Income Tax Expense (8 ) (14 ) (43 )% (27 ) (39 ) (31 )% Net Income (Loss) $ 85 $ (21 ) NM $ 248 $ (123 ) NM ___________________ NM - Not meaningful Discussion of all significant variances: Revenue by Service and Product Offering: Three Months Ended September 30, Nine Months Ended September 30, (dollars in millions) 2014 2013 Change % 2014 2013 Change % Core Network Services Revenue: Colocation and Datacenter Services $ 147 $ 144 2 % $ 438 $ 431 2 % Transport and Fiber 511 483 6 % 1,521 1,439 6 % IP and Data Services 590 536 10 % 1,751 1,576 11 % Voice Services (Local and Enterprise) 234 234 - % 708 702 1 % Total Core Network Service Revenue 1,482 1,397 6 % 4,418 4,148 7 % Wholesale Voice Services and Other Revenue 147 172 (15 )% 445 563 (21 )% Total Revenue $ 1,629 $ 1,569 4 % $ 4,863 $ 4,711 3 % Revenue increased 4% to $1.629 billion in the three months ended September 30, 2014 compared to $1.569 billion in the same period of 2013 and increased 3% to $4.863 billion in the nine months ended September 30, 2014, from $4.711 billion in the same period of 2013. The increase was driven by growth in Core Network Services revenue from enterprise customers partially offset by declines in Wholesale Voice Services and Other Revenue. 45-------------------------------------------------------------------------------- Table of Contents The Company experienced continued growth in its IP and data services and transport and fiber services during the three and nine months ended September 30, 2014 compared to the same periods of 2013 driven primarily by end user customer demand for content delivery over the Internet, VPN and bandwidth in the enterprise channel as well as increases in professional services fees. The Company also experienced modest growth in colocation and datacenter services and voice services during the three and nine months ended September 30, 2014. Core Network Services revenue increased in the North America and Latin America regions during the three months ended September 30, 2014 compared to the same period of 2013. Core Network Services revenue increased in the North America, EMEA and Latin America regions during the nine months ended September 30, 2014 compared to the same period of 2013. The increase in revenue was a result of growth in services provided to the existing enterprise customer base and the acquisition of new customers in the enterprise channel. These increases were partially offset by decreases in wholesale channel revenue in EMEA and due to the appreciation of the U.S. dollar against currencies in EMEA and Latin America. Wholesale Voice Services and Other revenue decreased in the three and nine months ended September 30, 2014 compared to the same periods of 2013 primarily as a result of declines in usage as customers transition to IP voice services. The Company continues to manage its combined wholesale voice services platform for profitability. Wholesale Voice Services revenue decreased in North America and EMEA in the three and nine months ended September 30, 2014 compared to the same period of 2013, due to competitive pressures and the Company's focus on maintaining or growing its profitability. Wholesale Voice Services and Other revenue increased in Latin America in the three and nine months ended September 30, 2014 compared to the same periods of 2013 due to expansion of services provided to existing customers. Network Access Costs include leased capacity, right-of-way costs, access charges, satellite transponder lease costs and other third-party costs directly attributable to providing access to customer locations from the Level 3 network, but excludes Network Related Expenses, and depreciation and amortization. Network Access Costs do not include any employee expenses or impairment expenses; these expenses are allocated to Network Related Expenses or Selling, General and Administrative Expenses. Network Access Costs as a percentage of total revenue was 37% in the three months ended September 30, 2014 compared to 39% in the same period of 2013 and was 38% in the nine months ended September 30, 2014 compared to 39% in the same period of 2013. The decrease is primarily due to an improving mix of higher profit on-net Core Network Services and a decrease in lower profit Wholesale Voice Services and Other Revenue. Additionally, the Company continues to implement initiatives to reduce both fixed and variable network expenses. Network Related Expenses include certain expenses associated with the delivery of services to customers and the operation and maintenance of the Level 3 network, such as facility rent, utilities, maintenance and other costs, each related to the operation of its communications network, as well as salaries, wages and related benefits (including non-cash stock-based compensation expenses) associated with personnel who are responsible for the delivery of services as well as operation and maintenance of its communications network, and accretion expense on asset retirement obligations, but excludes depreciation and amortization. Network Related Expenses decreased to $307 million from $314 million in the three months ended September 30, 2014 and 2013, and to $901 million from $916 million in the nine months ended September 30, 2014 and 2013, respectively. The decrease was attributable to the rationalization and renegotiation of vendor services for network maintenance as well as contracting costs. 46-------------------------------------------------------------------------------- Table of Contents Depreciation and Amortization decreased 8% to $187 million in the three months ended September 30, 2014 from $203 million in the same period of 2013 and decreased 6% to $558 million in nine months ended September 30, 2014 from $596 million in the same period of 2013. The decrease is primarily attributable to a change in the estimated useful lives of certain of the Company's property, plant and equipment that resulted in a reduction of depreciation expense of $75 million in the nine months ended September 30, 2014 compared to the same periods of 2013. The change in accounting estimate was applied on a prospective basis effective January 1, 2014, as required under the accounting standard related to changes in accounting estimates. Selling, General and Administrative Expenses ("SG&A Expenses") includes the salaries, wages and related benefits (including non-cash, stock-based compensation expenses) and the related costs of corporate and sales personnel, travel, insurance, non-network related rent, advertising and other administrative expenses. SG&A Expenses decreased 9% to $266 million in the three months ended September 30, 2014 compared to $292 million in the same period of 2013 and decreased 12% to $788 million in the nine months ended September 30, 2014 compared to $899 million in the same period of 2013. The decrease is primarily due to lower employee cash compensation and other employee related costs, professional fees, vendor services and other discretionary costs and the release of legal and transaction tax reserves as a result of changes in the estimated liability. Professional fees and vendor services and other discretionary costs decreased primarily due to the rationalization and renegotiation of vendor services and lower travel and entertainment costs. SG&A Expenses in the three months ended September 30, 2014 includes $7 million of transaction and integration fees related to the acquisition of tw telecom. Non-cash, stock-based compensation expense included in the three and nine months ended September 30, 2014, are $22 million and $48 million, respectively, and in the three and nine months ended September 30, 2013, are $30 million and $115 million, respectively, related to grants of outperform stock options, restricted stock units, performance restricted stock units, accruals for the Company's annual discretionary bonus, incentive and retention plans and shares issued for the Company's matching contribution for the 401(k) plan. Approximately $19 million and $22 million of non-cash stock-based compensation expense was recorded in SG&A Expenses during the three months ended September 30, 2014 and 2013, respectively, and approximately $42 million and $90 million of non-cash stock-based compensation expense was recorded in SG&A Expenses during the nine months ended September 30, 2014 and 2013, respectively. Approximately $3 million and $8 million of non-cash stock-based compensation expense was recorded in Network Related Expenses during the three months ended September 30, 2014 and 2013, respectively, and approximately $6 million and $25 million of non-cash stock-based compensation expense was recorded in Network Related Expenses during the nine months ended September 30, 2014 and 2013, respectively. The total decrease in non-cash, stock-based compensation expense is primarily due to the reallocation of the Company's 2014 annual discretionary bonus to be paid entirely in cash compared to the 2013 allocation of 60% equity and 40% cash. In April 2013, the Company announced that Jeff K. Storey had been appointed by the Board of Directors, effective immediately, to be the Company's President and Chief Executive Officer. As a result of the departure of James Q. Crowe, the Company incurred a charge of approximately $23 million in the second quarter of 2013 which was recorded in SG&A Expenses, consisting of $6 million of additional cash compensation expense and $17 million in non-cash compensation expense related to the vesting of certain of Mr. Crowe's long-term incentive awards payable under the terms of his employment agreement. Adjusted EBITDA, as defined by the Company, is net income (loss) from the Consolidated Statements of Operations before (1) income tax benefit (expense), (2) total other income (expense), (3) non-cash impairment charges included within network related expenses and selling, general and administrative expenses, (4) depreciation and amortization expense and (5) non-cash stock compensation expense included within network related expenses and selling, general and administrative expenses. 47-------------------------------------------------------------------------------- Table of Contents Adjusted EBITDA is not a measurement under GAAP and may not be used in the same way by other companies. Management believes that Adjusted EBITDA is an important part of the Company's internal reporting and is a key measure used by management to evaluate profitability and operating performance of the Company and to make resource allocation decisions. Management believes such measurement is especially important in a capital-intensive industry such as telecommunications. Management also uses Adjusted EBITDA to compare the Company's performance to that of its competitors and to eliminate certain non-cash and non-operating items in order to consistently measure from period to period its ability to fund capital expenditures, fund growth, service debt and determine bonuses. Adjusted EBITDA excludes non-cash impairment charges and non-cash stock compensation expense because of the non-cash nature of these items. Adjusted EBITDA also excludes interest income, interest expense and income tax benefit (expense) because these items are associated with the Company's capitalization and tax structures. Adjusted EBITDA also excludes depreciation and amortization expense because these non-cash expenses reflect the effect of capital investments which management believes are better evaluated through cash flow measures. Adjusted EBITDA excludes net other income (expense) because these items are not related to the primary operations of the Company. There are limitations to using non-GAAP financial measures such as Adjusted EBITDA, including the difficulty associated with comparing companies that use similar performance measures whose calculations may differ from the Company's calculations. Additionally, this financial measure does not include certain significant items such as interest income, interest expense, income tax benefit (expense), depreciation and amortization expense, non-cash impairment charges, non-cash stock compensation expense and net other income (expense). Adjusted EBITDA should not be considered a substitute for other measures of financial performance reported in accordance with GAAP. The following information provides a reconciliation of Net Income (Loss) to Adjusted EBITDA as defined by the Company: Three Months Ended September 30, Nine Months Ended September 30, (dollars in millions) 2014 2013 2014 2013 Net Income (Loss) $ 85 $ (21 ) $ 248 $ (123 ) Income Tax Expense 8 14 27 39 Total Other Expense 169 159 507 531 Depreciation and Amortization 187 203 558 596 Non-Cash Compensation Expense 22 30 48 115 Adjusted EBITDA $ 471 $ 385 $ 1,388 $ 1,158 Consolidated Adjusted EBITDA was $471 million in the three months ended September 30, 2014 compared to $385 million in the same period of 2013 and $1,388 million in the nine months ended September 30, 2014 compared to $1,158 million in the same period of 2013. The increase in Adjusted EBITDA is primarily attributable to growth in the Company's higher incremental profit Core Network Services revenue and continued improvements in network access costs and lower Network Related Expenses and SG&A Expenses, including the benefit of headcount reduction initiatives in 2013. Adjusted EBITDA increased in the North America and Latin America regions in the three and nine months ended September 30, 2014, compared to 2013 as a result of growth in Core Network Services revenue and initiatives resulting in reduced fixed and variable network expenses. These increases were partially offset by a decrease in Wholesale channel revenue for North America and EMEA. Adjusted EBITDA was flat in EMEA in the three months ended September 30, 2014 and decreased during the nine 48-------------------------------------------------------------------------------- Table of Contents months ended September 30, 2014 compared to 2013 due to decreases in Wholesale channel revenue and higher network access costs. See Note 9 - Segment Information in the notes to Consolidated Financial Statements for additional information on Adjusted EBITDA by region. Historically, the Company has paid a portion of employee annual bonuses with shares of its common stock. Beginning in 2014, the Company is accruing the entire bonus compensation within Network Related Expenses and SG&A Expenses as cash compensation, which will be paid in 2015. Interest Expense decreased 4% to $159 million in the three months ended September 30, 2014 from $165 million in the same period of 2013 and decreased 8% to $459 million in the nine months ended September 30, 2014 from $501 million in the same period of 2013. Interest expense decreased as a result of lower cost of borrowing on refinanced debt for the three and nine months ended September 30, 2014 compared to the same period of 2013. The Company expects annual interest expense in 2014 of approximately $645 million based on current interest rates on the Company's debt outstanding as of September 30, 2014, including $45 million related to the debt incurred for the acquisition of tw telecom. Other, net is primarily comprised of gains and losses on the sale of non-operating assets, foreign currency gains and losses and other income and expense. Other, net was $11 million and $49 million of expense in the three and nine months ended September 30, 2014 compared to $23 million of income and $13 million million of expense in the three and nine months ended September 30, 2013. The Other, net expense in the three and nine months ended September 30, 2014 and in the nine months ended September 30, 2013 was incurred primarily due to foreign currency losses attributable to the devaluation of the Venezuelan bolivar, as discussed below, and other foreign currency losses related to the appreciation of the U.S. dollar for certain intercompany balances denominated in the local currency of foreign subsidiaries in EMEA and Latin America that are not considered to be long-term in nature. The Other, net income in the three months ended September 30, 2013 was primarily due to foreign currency gains attributable to the appreciation of the local currencies relative to the U.S. dollar for certain intercompany balances denominated in the local currency of foreign subsidiaries in EMEA that are not considered to be long-term in nature. Effective February 13, 2013, the Venezuelan government devalued the Venezuelan bolivar by increasing the official rate from 4.30 Venezuelan bolivares to the U.S. dollar to 6.30 Venezuelan bolivares to the U.S. dollar. This devaluation reduced the Company's net monetary assets by $22 million based on the bolivar balances as of February 13, 2013, resulting in a charge of $22 million which was recognized in Other, net in the Consolidated Statement of Operations in the first quarter of 2013. During the first quarter 2014, the Venezuela government enacted additional changes to the country's foreign exchange system. The government expanded the types of transactions that may be allowed via the weekly auctions under the Complementary System of Foreign Currency Acquirement ("SICAD 1"). The Venezuela government also announced the replacement of its existing foreign currency administration with the National Center for Foreign Commerce ("CENCOEX"). Entities may seek approval to transact through CENCOEX at the official rate of 6.30 Venezuelan bolivares to the U.S. dollar; however, certain transactions may be approved at the latest SICAD 1 rate, depending on the entity's facts and circumstances. In the three months ended June 30, 2014, based on additional experience with the new foreign exchange mechanisms, the Company concluded that the most appropriate rate is currently SICAD 1, or 10.6 Venezuelan bolivares to the U.S. dollar as of June 30, 2014. Accordingly, the Company recognized a loss of approximately $34 million in the three months ended June 30, 2014, resulting from the devaluation of Venezuelan bolivar denominated monetary assets and liabilities from the official rate of 6.3 to the SICAD 1 rate, $30 million of which was attributable to cash in Venezuela. As of September 30, 2014, 49-------------------------------------------------------------------------------- Table of Contents SICAD 1 was 12.0 Venezuelan bolivares to the U.S. dollar. The increase in SICAD 1 during the three months ended September 30, 2014 resulted in an additional loss of $7 million. The Company continues to monitor closely its foreign currency risk in Venezuela. Income Tax Expense was $8 million and $27 million in the three and nine months ended September 30, 2014 compared to $14 million and $39 million in the three and nine months ended September 30, 2013. The income tax expense in all periods is primarily related to taxes in foreign jurisdictions. The Company incurs tax expense attributable to income in various Level 3 subsidiaries that are required to file state or foreign income tax returns on a separate legal entity basis. The Company also recognizes accrued interest and penalties in income tax expense related to uncertain tax benefits. Income tax for the three and nine months ended September 30, 2014 is not necessarily indicative of income tax expense for the year ended December 31, 2014. The Company's tax rate is volatile and may move up or down with changes in, among other things, the amount and source of income or loss, its ability to utilize foreign tax credits, changes in tax laws and the movement of liabilities established for uncertain tax positions as statutes of limitations expire or positions are otherwise effectively settled. On October 31, 2014, the Company completed the acquisition of tw telecom through a tax-free reorganization. Level 3 will record the acquired tw telecom assets and liabilities at their estimated fair value as of the date of the merger. For tax purposes, Level 3 will record the carryover tax basis of tw telecom's assets and liabilities. The Company expects that this will result in material deferred tax liabilities due to differences in the recorded values for tangible and intangible assets. These newly created deferred tax liabilities as a result of acquisition accounting will offset tw telecom's deferred tax assets as well as a portion of Level 3's deferred tax assets resulting in a valuation allowance release in the fourth quarter of 2014 that is expected to be significant. The valuation of tw telecom's assets and liabilities is preliminary and could change materially along with the amount of the newly created deferred tax liability and the one-time release of the valuation allowance. Financial Condition- For the Nine Months Ended September 30, 2014 and 2013 Cash flows from operating activities, investing activities and financing activities for the nine months ended September 30, 2014 and 2013 are summarized as follows: Nine Months Ended September 30, (dollars in millions) 2014 2013 ChangeNet Cash Provided by Operating Activities $ 765 $ 327 $ 438 Net Cash Used in Investing Activities (617 ) (556 ) (61 ) Net Cash Used in Financing Activities (9 ) (220 ) 211 Effect of Exchange Rates on Cash and Cash Equivalents (41 ) (23 ) (18 ) Net Change in Cash and Cash Equivalents $ 98 $ (472 ) $ 570 Operating Activities Cash provided by operating activities was $765 million in the nine months ended September 30, 2014 compared to cash provided by operating activities of $327 million in the same period of 2013. The increase in cash provided by operating activities was primarily due to growth in earnings and lower interest payments. Investing Activities 50-------------------------------------------------------------------------------- Table of Contents Cash used in investing activities increased in the nine months ended September 30, 2014 compared to the same period of 2013 primarily as a result of an increase in capital expenditures, which totaled $608 million in the nine months ended September 30, 2014 and $571 million in the same period of 2013. Financing Activities Cash used in financing activities of $9 million in the nine months ended September 30, 2014, decreased compared to $220 million used in financing activities in the same period of 2013 due to lower net payments of debt and capital leases during 2014 compared the same period of 2013 primarily as a result of the repayment at maturity of $172 million of the 15% Convertible Notes due January 15, 2013. Effect of Exchange Rates on Cash and Cash Equivalents The effect of exchange rates on cash and cash equivalents in the nine months ended September 30, 2014 and 2013 was a loss of $41 million and $23 million, respectively. The effect of exchange rates on cash and cash equivalents in the nine months ended September 30, 2014 and 2013 was primarily due to the devaluation of the Venezuelan bolivar, which reduced the Company's unrestricted cash and cash equivalents by $30 million in the second quarter of 2014 and $21 million in the first quarter of 2013. In addition, SICAD 1 increased from 10.6 to 12.0 Venezuelan bolivares per U.S. dollar resulting in a foreign currency loss of approximately $7 million during the quarter ended September 30, 2014. Liquidity and Capital Resources The Company recognized net income of $248 million in the nine months ended September 30, 2014 and a net loss of $123 million in the same period of 2013. The Company used cash of $608 million for capital expenditures and $9 million for financing activities in the nine months ended September 30, 2014. This compares to $571 million of cash used for capital expenditures and $220 million of cash flows used in financing activities in the nine months ended September 30, 2013. Net cash interest payments are expected to decrease to approximately $580 million in 2014 from $645 million in 2013 based on current interest rates on the Company's debt outstanding as of September 30, 2014, including $15 million related to the debt incurred for the acquisition of tw telecom. Capital expenditures for 2014 are expected to remain relatively consistent as a percentage of revenue as in 2013, as the Company invests in base capital expenditures (estimated capital required to keep the network operating efficiently and support new service development) with the remaining capital expenditures expected to be success-based, which is tied to a specific customer revenue opportunity, and project-based where capital is used to expand the network based on the Company's expectation that the project will eventually lead to incremental revenue. In August 2014, the Company issued $1.0 billion in aggregate principal amount of its 5.375% Senior Notes due 2022 in a private offering. The net proceeds were used to finance the cash portion of the merger consideration payable to tw telecom stockholders and to refinance certain existing indebtedness of tw telecom inc., including fees, in connection with the closing of the Merger. In October 2014, Level 3 Financing, Inc. issued $2 billion Tranche B 2022 Term Loan. The Tranche B 2022 Term Loan included an up front payment to the Tranche B 2022 Term Loan lenders of 0.75 percent of par. The aggregate net proceeds of Level 3 Financing's Tranche B 2022 Term Loan were used to finance the cash portion of the merger consideration payable to tw telecom's stockholders and to refinance certain existing indebtedness of tw telecom, including fees and premiums, in connection with the closing of the Merger. The Floating Rate Senior Notes due 2018 issued by Level 3 Financing, Inc. in November 2013 were not originally registered under the Securities Act of 1933, as amended. During the fourth quarter of 2014, 51-------------------------------------------------------------------------------- Table of Contents all of the originally placed notes were exchanged for a new issue of Floating Rate Senior Notes due 2018 with identical terms and conditions, other than those related to registration rights, in a registered exchange offer and are now freely tradeable. The Floating Rate Senior Notes due 2018 are guaranteed by Level 3 Communications, Inc. and Level 3 Communications, LLC. The 6.125% Senior Notes due 2021 issued by Level 3 Financing, Inc. issued in November 2013 were not originally registered under the Securities Act of 1933, as amended. During the fourth quarter of 2014, all of the originally placed notes were exchanged for a new issue of 6.125% Senior Notes due 2021 with identical terms and conditions, other than those related to registration rights, in a registered exchange offer and are now freely tradeable. The 6.125% Senior Notes due 2021 are guaranteed by Level 3 Communications, Inc. and Level 3 Communications, LLC. As of September 30, 2014, the Company had contractual debt obligations, including capital lease obligations, and excluding interest, discounts on debt issuance and fair value adjustments, of $22 million that mature in the remaining three months of 2014, $483 million in 2015, which includes the Company's $475 million aggregate principal amount of 7% Convertible Senior Notes due 2015 that are convertible at a price of approximately $27 per share and $7 million in 2016. The Company had $729 million of cash and cash equivalents on hand at September 30, 2014. The Company also had $1.041 billion of current and non-current restricted cash and securities used to collateralize outstanding letters of credit and certain performance and operating obligations of the Company at September 30, 2014, including $1.0 billion for the tw telecom acquisition. In addition, $50 million of the Company's total cash and cash equivalents as of September 30, 2014 was held in Venezuelan bolivares by a Venezuelan subsidiary. In light of the Venezuelan exchange control regime, none of such $50 million may be transferred to the Company in the form of loans, advances or cash dividends without the consent of the Venezuelan government. During the first quarter 2014, the Venezuela government enacted additional changes to the country's foreign exchange system. The government expanded the types of transactions that may be allowed via the weekly auctions under SICAD 1. The Venezuela government also announced the replacement of its existing foreign currency administration with the CENCOEX. Entities may seek approval to transact through CENCOEX at the official rate of 6.3 Venezuelan bolivares to the U.S. dollar; however, certain transactions may be approved at the latest SICAD 1 rate, depending on the entity's facts and circumstances. Participation in SICAD is controlled by the Venezuela government, and Exchange Agreement No. 25 ("EA25") issued in January 2014 stated that the rate of exchange established in the most recent SICAD 1 auction will be used for payments related to international investments, royalties, and the use and exploitation of patents, trademarks, licenses franchises and technology. In addition, the Venezuelan government approved a new Law on Fair Prices, which provides that the maximum profit for all of the activities related to the production, manufacturing, import, storage, transportation, distribution and marketing of all goods and services in the territory of the Bolivarian Republic of Venezuela shall not exceed 30% per year. Specific regulations regarding the application of the Law on Fair Prices to the telecommunication industry and, more specifically, the Company's business activities in Venezuela have not been released. The Venezuela government also announced the plans for a third currency exchange mechanism ("SICAD 2"), which is intended to more closely resemble a market-driven exchange rate than the rates provided by Venezuela's other mechanisms. At September 30, 2014, the CENCOEX official exchange rate was 6.3, the SICAD 1 exchange rate was 12.0 and the SICAD 2 exchange rate was 50.0 Venezuelan bolivares to the U.S. dollar. The $50 million value of the Company's bolivar denominated cash balance at September 30, 2014 reflects the foreign exchange loss that resulted from devaluing the Company's assets and liabilities from the official CENCOEX rate of 6.3 to the SICAD 1 exchange rate of 12.0 Venezuelan bolivares to the U.S. dollar during the nine months ended September 30, 2014. 52-------------------------------------------------------------------------------- Table of Contents The Company continues to monitor activity in Venezuela with respect to exchange rates as the resolution of the uncertainty created with these developments along with any future developments could ultimately result in a negative effect to the Company's results of operations and cash flows in Venezuela for any amounts held in bolivares. Given the insignificant volume of bolivar denominated transactions, the effect to the Company's operations is not expected to be material other than a possible charge for the Company's cash and cash equivalents held in bolivares. The Company currently has the ability to repatriate cash and cash equivalents into the United States without paying or accruing U.S. taxes. Level 3 does not currently intend to repatriate any of its foreign cash and cash equivalents from entities outside of Latin America. The Company has no restrictions on its ability to repatriate foreign cash and cash equivalents, other than conversion and repatriation restrictions in Venezuela, as needed to fund operations in the United States, including debt service. On October 31, 2014, the Company and two of its subsidiaries completed the merger with tw telecom and tw telecom became a wholly owned subsidiary of the Company through a tax-free, stock and cash reorganization. As a result of the Merger, (1) each issued and outstanding share of common stock of tw telecom was exchanged for 0.7 shares of Level 3 common stock and $10 in cash (together the "merger consideration"); (2) the outstanding stock options were canceled and holders received the merger consideration, net of aggregate per share exercise price; (3) each restricted stock unit award was canceled and the holders received the merger consideration; and (4) each restricted stock unit was immediately vested and canceled and holders received the merger consideration. In connection with the closing of the Merger, Level 3 Financing amended its existing credit agreement to incur an additional $2 billion of borrowings through the Tranche B 2022 Term Loan. The aggregate net proceeds of Level 3 Financing's Tranche B 2022 Term Loan issued in October 2014 were used to finance the cash portion of the merger consideration payable to tw telecom's stockholders and to refinance certain existing indebtedness of tw telecom, including fees and premiums, in connection with the closing of the Merger (see Note 12 - Subsequent Events for additional information). In addition, the $1.0 billion of proceeds from the 5.375% Senior Notes due 2022 raised in August 2014 (see Note 6 - Long-Term Debt) by an indirect, wholly owned subsidiary were deposited into an escrow account. On October 31, 2014, following the consummation of the Merger and the satisfaction of certain escrow release conditions, the 5.375% Senior Notes were assumed by Level 3 Financing and the funds were released from the escrow account. The net proceeds from the 5.375% Senior Notes were used to finance the cash portion of the merger consideration payable to tw telecom's stockholders under the Merger Agreement and to refinance certain existing indebtedness of tw telecom, including fees and premiums, in connection with the closing of the Merger and for general corporate purposes. On October 30, 2014, the Company increased the number of authorized shares of common stock by 100,000,000 shares to 433,333,333. As a result of the Merger, the Company issued approximately 96.9 million shares of Level 3 common stock to former holders of tw telecom common shares, stock options, restricted stock and restricted stock units. In addition, Level 3 called for redemption and discharged or repaid approximately $1.793 billion of tw telecom's outstanding consolidated debt. The shares of tw telecom common stock, which previously traded under the symbol "TWTC", ceased trading on the NASDAQ Global Select Market ("NASDAQ") at the close of trading on October 31, 2014 and were delisted from NASDAQ as of October 31, 2014. Based on the number of Level 3 shares issued, the closing stock price of $46.91 on October 31, 2014, the cash paid to the former holders of tw telecom common stock and the $1.793 billion of debt of tw telecom called for redemption and discharged or repaid, the aggregate consideration for acquisition accounting, including assumed debt, approximated $8.1 billion. Based on information available at this time, the Company believes that its current liquidity and anticipated future cash flows from operations will be sufficient to fund its business for at least the next twelve months. 53-------------------------------------------------------------------------------- Table of Contents The Company may need to refinance all or a portion of its indebtedness at or before maturity and cannot provide assurances that it will be able to refinance any such indebtedness on commercially reasonable terms or at all. In addition, the Company may elect to secure additional capital in the future, at acceptable terms, to improve its liquidity or fund acquisitions. In addition, in an effort to reduce future cash interest payments as well as future amounts due at maturity or to extend debt maturities, the Company may, from time to time, issue new debt, enter into debt for debt, debt for equity or cash transactions to purchase its outstanding debt securities in the open market or through privately negotiated transactions. The Company will evaluate any such transactions in light of the existing market conditions and the possible dilutive effect to stockholders. The amounts involved in any such transaction, individually or in the aggregate, may be material. In addition to raising capital through the debt and equity markets, the Company may sell or dispose of existing businesses, investments or other non-core assets. Consolidation of the communications industry may continue. The Company will continue to evaluate consolidation opportunities and could make additional acquisitions in the future. Off-Balance Sheet Arrangements Level 3 has not entered into off-balance sheet arrangements. 54-------------------------------------------------------------------------------- Table of Contents |